Companies have yet another new accounting standard to adopt, but this time they can’t wait to get started.
That’s the word from accounting experts who are practically giddy over the latest release from the Financial Accounting Standards Board. The new standard on hedge accounting has been a long time coming, they say.
“This is exciting stuff in our space,” says Helen Kane, president of Hedge Trackers. “Frankly, it’s reducing compliance risk.”
Public company accounting departments have taken a beating over the past several months as they have tried to get ready for the new revenue recognition standard that takes effect in a few short months with the start of the 2018 reporting year. And soon after, they’ll face another big push to put a new lease accounting standard into effect by 2019.
That may be the only thing tempering any enthusiasm for adopting FASB’s newest release, Accounting Standards Update No. 2017-12, which softens and simplifies the accounting requirements around derivatives and hedging. “There seems to be a lot of excitement around this guidance,” says Ryan Brady, a partner at Grant Thornton. “That’s a rare exception to some of the more recent standard setting.”
Hedge accounting has earned a bad reputation, says Reza van Roosmalen, a managing director at KPMG. “It’s very compliance-driven, could be very onerous, and very administratively burdensome,” he says. “You can get it wrong very easily.”
“This eliminates the confusing numbers and non-value-add associated with measuring amounts of ineffectiveness. That whole concept is out. That will take a lot of the low-value-add audit review and expense out of hedging.”
Helen Kane, President, Hedge Trackers
A lot of companies have curbed their use of hedging just to minimize their risk of mistakes, or worse, restatement, van Roosmalen says. Many of the restatements of the early 2000s arose due to mistakes applying hedge accounting rules.
“A lot of institutions have not elected to apply hedge accounting in the last two decades partly because of this,” says van Roosmalen. “It generally didn’t have a lot of appeal for institutions unless hedging was really part of the core business and had been driving a lot of volatility in the income statement.”
The 20-year-old guidance on hedge accounting was adopted in 1998 to give investors greater visibility into hedges, which are transactions companies enter to offset various types of financial or operational risks to smooth out volatility. “I believe FASB was trying to put its finger in the dike,” says Kane. “A lot of companies were hedging without an appropriate control structure.”
CHANGES TO HEDGE ACCOUNTING
What will the changes to FASB’s hedge accounting standard accomplish?
Alignment of Hedge Accounting with Risk Management Activities
The amendments will expand hedge accounting for both financial and non-financial risk components to better align hedge accounting with a company’s risk management activities. Specifically, the amendments permit more flexibility in hedging interest rate risk for both variable rate and fixed rate financial instruments, and introduce the ability to hedge risk components for nonfinancial hedges.
Current GAAP contains limitations on how a company can measure changes in fair value of the hedged item attributable to interest rate risk in certain fair value hedging relationships. Stakeholders emphasized that this did not reflect the economics of the hedging relationship. Therefore, the following refinements were made to the measurement of the hedged item:
Measure the hedged item in a partial-term fair value hedge of interest rate risk by assuming the hedged item has a term that reflects only the designated cash flows being hedged
Consider only how changes in the benchmark interest rate affect a decision to settle a prepayable instrument before its scheduled maturity when calculating the fair value of the hedged item
Measure the fair value of the hedged item using the benchmark rate component of the contractual coupon cash flows determined at hedge inception.
The amendments also expand fair value hedges of interest rate risk for closed portfolios of prepayable financial assets or one or more beneficial interests secured by a portfolio of prepayable financial instruments. Under the amendments, a company may designate an amount that is not expected to be affected by prepayments, defaults, and other events affecting the timing and amount of cash flows (the “last-of-layer” method). Under this designation, prepayment risk is not incorporated into the measurement of the hedged item.
For fair value, cash flow, and net investment hedges, the reporting of amounts excluded from the assessment of hedge effectiveness will change to allow entities to use an amortization approach or to continue mark-to-market accounting consistent with current GAAP.
Elimination of the Separate Measurement and Recording of Hedge Ineffectiveness
To simplify the reporting of hedge results for financial statement preparers and decrease the complexity of understanding hedge results for investors, the FASB has eliminated the separate measurement and reporting of hedge ineffectiveness. Mismatches between changes in value of the hedged item and hedging instrument may still occur but they will no longer be separately reported. For cash flow and net investment hedges, all changes in value of the hedging instrument included in the assessment of effectiveness will be deferred in other comprehensive income and recognized in earnings at the same time that the hedged item affects earnings.
Improvements to Presentation and Disclosure
The amendments will enhance the presentation of hedge results in the financial statements and disclosures about hedging activities by:
Requiring changes in the value of the hedging instrument be presented in the same income statement line item as the earnings effect of the hedged item
Amending the current tabular disclosure of hedging activities to focus on the effect of hedge accounting on individual income statement line items
Requiring a new disclosure that will provide investors with more information about basis adjustments in fair value hedges.
Simplifications Related to Effectiveness Assessments
The ASU also includes targeted improvements to simplify assessments of hedge effectiveness. Those simplifications will:
Allow a company to perform subsequent assessments of hedge effectiveness qualitatively if certain conditions are met
Allow companies more time to perform the initial quantitative hedge effectiveness assessment
Allow a company to apply the “long-haul” method for assessing hedge effectiveness when use of the shortcut method was not or no longer is appropriate if certain conditions are met
Clarify that a company may apply the “critical terms match” method for a group of forecasted transactions if the transactions occur and the derivative matures within the same 31-day period or fiscal month, and the other requirements for applying the critical terms match method are satisfied.
All of that pre-dates Sarbanes-Oxley, with its requirements for companies to put in place and report on internal controls over financial reporting, says Kane. The accounting requirements, with the internal control heaped on top, led to a great deal of onerous, and sometimes even nonsensical, testing.
“The testing regimes started to have to be applied to a lot of nonsense cases,” says Kane. “People had to go through a lot of hoops and regression analysis to show, for example, that the euro is highly related to the euro.”
By about 2007, as FASB sought major overhauls in accounting standards to converge U.S. GAAP with International Financial Reporting Standards, hedge accounting made the list of areas where some improvement was warranted. It fell low on the agenda, however, behind other areas of financial instruments, as well as revenue recognition and leasing.
Hedging made it back to the top of FASB’s priority list as the board sought to make targeted improvements to GAAP that would also simplify GAAP. The new standard is meant to eliminate the most problematic complexity and help companies align the accounting for hedge transactions with their risk management activities. The result, says FASB, is a standard that better reflects the economics behind hedging.
FASB says the changes from the old hedge accounting standard to the current amendments achieve four major objectives. First, the new standard expands hedge accounting for non-financial and financial risk components and revises measurement methods to make the accounting more closely aligned with how companies manage risk.
That’s welcome news, particularly for operating companies that might want to hedge accounting for commodities but had difficulty doing so under existing rules, says van Roosmalen. Financial institutions were already allowed to hedge specific components of risk, like changes in interest rates, he says. Non-financial companies have more difficulty with that because they have not been allowed to apply hedge accounting to a non-financial component hedge strategy. “Non-financial companies are welcoming this because it opens the door for much more hedging,” he says.
Second, it eliminates separate measurement and reporting of hedge ineffectiveness to cut the complexity of preparing and understanding hedge results. “This eliminates the confusing numbers and non-value-add associated with measuring amounts of ineffectiveness,” says Kane. “That whole concept is out. That will take a lot of the low-value-add audit review and expense out of hedging.”
Third, the new standard changes hedge disclosures and the presentation of hedge results to make them more transparent, more comparable, and easier to understand, FASB says. That will necessitate some additional reporting, says Kane, to produce a single table to show all the effects of hedging in one place. “I don’t believe it presents any new information,” she says. “It consolidates all the information into one place.”
Finally, it simplifies the assessments of hedge effectiveness, making hedge accounting easier and less costly on companies. “A lot of us are predicting companies will be able to devote less resources now to the maintenance of hedging,” says Rob Royall, a partner at EY. Some may redirect resources to assuring they qualify for hedge accounting at the front end, and others may reduce resources overall depending on their facts and circumstances, he says.
“Many companies have been too frustrated with the burden of trying to maintain hedge accounting and may now decide if it’s easier or more reasonable to do,” says Royall. “Maybe it will be in their best interest to look at using derivatives again. At least companies are contemplating that.”
The new standard takes effect in 2019 but allows early adoption, which experts say many companies will be eager to pursue. Early adopters, however, have to be sure they understand the transition provisions, says Jon Howard, senior consultation partner at Deloitte & Touche.
“When you adopt, it’s not just for new hedging strategies going forward,” he says. “You can refine existing hedges too, but you have to do it all at once when you implement.”
Where companies might be planning to revise any existing hedges as part of their adoption, that may lead to some pause before jumping into the new accounting, says Howard. He expects companies will accelerate their work on new hedge accounting as soon as they have their revenue recognition processes up and running in early 2018.